fi360 Blog

An interview with Carl Richards of Behavior Gap

Carl Richards has a mission to create better investors. For years in the brokerage industry and as a financial planner, he saw average investors earning returns dramatically less than the average mutual funds they were investing in. The problem is investor behavior.  Investors continually make the classic mistakes that result in their leaving money on the table that smarter investment behavior could have earned them.

He named the phenomenon the Behavior Gap, and he continues to explore and share how our relationship with money, and what we choose to value, can impact our lives.  

Carl was kind enough to answer some questions for us related to his mission and to fiduciary issues.

fi360: One of Behavior Gap’s signature themes is that the process is far more important than the product and planning is more important than the plan. What does this mean in terms of the real value added by an advisor?

Carl Richards: We’re really talking about two related issues. The first is the product vs. process problem. For the longest time the traditional financial services had it backwards. They started with a product and tried to sell it to anyone that would listen without taking the time to understand if it was appropriate. I think that those of us who take the craft of advice seriously understand that the value is clearly in the ongoing process that we guide people through. The products we use at the end are just a byproduct. It seems to me that this attitude is becoming more and more accepted; now it’s just a matter of getting everyone to act that way.

The second issue deals with the idea that people really need a planner and not just a plan. Financial plans are worthless without the ongoing involvement of the planner. The more plan work I do, the less I think of it. Consider the massive amount of “assuming” that goes into a plan. Not only do we know that we are going to be wrong, it’s also out of date the moment we hit print. What clients want is a planner, someone that will help them navigate the financial landscape. They recognize we can’t know what will happen to them over the next 20 years. Clients just want to know we will be there to help them make smart decisions when things come up. The space shuttle is off course something like 95% of the time. When they formulate the flight plan, they know that. The value is not in the flight plan, but in the course corrections.

fi360: If investment decisions shouldn’t be made on investment performance alone, what signs should advisors be looking for when deciding to replace funds or make changes to an investment plan?

Fiduciary duty and adviser oversight remain regulatory hot topics

The House Financial Services Committee continued to make progress in moving along key regulatory reform legislation yesterday by approving the Private Fund Investment Advisers Registration Act.  If approved by the full House and Senate, the bill will require advisers to hedge funds and other private pools of capitals to register with the SEC.  Today, the Committee will get started with a vote on the Accountability and Transparency in Rating Agencies Act.  It will then move on to completing its markup of the Investor Protection Act, which seeks to extend the fiduciary standard to broker-dealers who provide personalized investment advice to retail investors. 

In her opening address at the SIFMA annual meeting this week, SEC Chairman Mary Schapiro continued to voice support for applying "a high fiduciary standard" to investment professionals providing advice rather than "watered-down, 'fair and reasonable' commercial standard."  FINRA CEO, Richard Ketchum, also gave remarks at the meeting, stating that his organization "wholeheartedly embraces the Administration's goal of harmonizing regulation of [broker-dealers and investment advisers]." 

In addition to the fiduciary issue, investment adviser oversight  appears to be another burning topic on legislators' and regulators' minds this week.  In particular, Congressman Paul Kanjorski is expected to offer an amendment to the Investor Protection Act that would seek to raise the $25 million assets under management threshold for investment adviser federal registration to $150 million in order to reduce the number of investment advisers subject to SEC regulation.  It's not clear, however, how much support the amendment will garner from other legislators.  State securities regulators previously advocated to Congress that the threshold be raised to $100 million, a change the SEC appears to be interested in considering and could make if legislators fail to act. 

Meanwhile, Ketchum again stated FINRA's desires to bring investment advisers under its oversight.  Despite these bold claims of FINRA's readiness to step up, NASAA, the main lobbying body for state regulators, has raised strong concerns that "SROs are inherently conflicted and are not independent." 

While it remains unclear whether and how Congress will ultimately address the adviser oversight issue, today's markup session could shed more light on legislators' thinking as well as mark a major milestone in the long debated fiduciary issue as the House Financial Oversight Committee moves closer to a vote.

Fiduciary Links: Duties of Investment Managers

While most of the fiduciary attention in the financial regulation overhaul discussions has been related to investment advisors, two interesting headlines in the last week put some focus on the fiduciary role of managers. The Senate Special Committee on Aging is holding hearings on target date funds this Wednesday. Specifically, the Committee wants to focus on the quality of funds being used, the asset allocation as the funds approach their target date, and conflicts of interests on the part of the investment managers.

In addition, a study by Morninstar found that most managers do not invest in their own funds, but those funds whose mangers do invest in them, perform better. While not a requirement for a manager to invest in their own funds, it does align compensation with the best interests of investors and is a part of Practice 2.6 in the Prudent Practices for Investment Managers handbook.

Fiduciary duties as they relate to investment advice will continue to dominate the headlines during the coming months of regulatory reform, but it should be worthwhile to pay attention to these stories regarding the duties of the managers as well.

On to the rest of the links...

In the news/commentary:

• Draft Investor Protection Act includes fiduciary standard for all investment advice, SEC as rulemaker
• Ketchum talks advisor oversight
• "The world of compliance of 2008 is dead," says the SEC's Compliance Office

From the organizations/associations/government/academia:

• The Committee for the Fiduciary Standard says SIFMA's proposal for regulatory reform doesn't do enough to protect investors
• Berkelely/CMU/Harvard paper says conflicts of interests among auditing firms contributed to financial scandals

From the blogs:

• Poor monitoring habits and not clearly identifying fiduciaries among comon fiduciary challenges
• Health Plan Law looks at a decision about a plan's language regarding delegation of fiduciary duty

Tweet of the week: @BrightScope: Hey industry, transparency is not just a fun buzzword anymore. #fiduciary

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

Fiduciary Discussions Push Forward in Washington

The House Financial Services Committee is set to continue its markup of key regulatory reform legislation and specifically will meet next Tuesday to consider the Investor Protection Act, key legislation that would extend the fiduciary duty to broker-dealers who provide investment advice.  In anticipation of the markup, a manager's amendment to the Investor Protection Act was released earlier this week. 

The amendment seeks to remedy "drafting errors" and "improve the intent of the bill." Most notable to the proposed expansion of the fiduciary duty is a clarification to the statutory language that would ensure that any standard of conduct adopted by the SEC for brokers, dealers, and investor advisors will be as strong as the current fiduciary standard applied to investment advisors. In addition, any disclosure rules adopted by the SEC would also need to address disclosure of conflicts of interest between the investment professional and the investor.   

Despite significant movement by the House Financial Services Committee to complete a legislative package by November, observers are still questioning whether financial reform will get done this year due to the Senate's focus on healthcare reform. In response to these concerns, Senator Carl Levin stated he believes there is enough momentum in the Senate to complete regulatory reform by year end. Levin specifically cited the strong leadership of Senate Banking Committee Chair Christopher Dodd and public anger over Wall Street abuses as the driving forces that will move regulatory reform toward completion.

Once legislation is complete, it will be up to regulatory agencies to carry the torch next year and implement changes. The SEC, in particular, provided another signal this week that it is willing take up the fiduciary issue and adopt a consistent standard for all investment professionals who provide personalized advice to investors. Indeed, in a joint report issued with the CFTC, the SEC called for a fiduciary duty to be applied to advisors who recommend commodities to investors. The recommendation specifically seeks to further reduce confusion in the marketplace about financial professionals' duties and apply a uniform fiduciary standard of care to all professionals providing similar services. Thus, it appears that legislators and regulators are eager to move the broad implementation of a fiduciary standard forward.

Intro to the Prudent Investment Practices

Not only do investment fiduciaries have a major role in the fiscal health of individual investors and of our country, they also carry major personal liability. And yet many fiduciaries either are unaware of the full extent of their responsibility or do not follow a defined process. Their success or failure is ultimately judged by the process they follow, rather than the specific decisions they make. For this reason, the Prudent Practices for Investment Fiduciaries were introduced as a guide for an investment process that covers all of the major responsibilities of an investment fiduciary. 

This is the first post in a new series we're introducing to the fi360 Blog, in which we'll highlight the individual Practices in order, beginning with today's post on the formation of the Practices. In the meantime, you can always visit the Practices page from our website to learn more and download PDF copies of the handbooks that detail the Practices, as well as other supporting documents and information.

The Practices were formed first by looking at the the major pieces of U.S. law governing investment fiduciaries: ERISA, UPIA, MPERS and UPMIFA. From these four laws, seven common principles, or, as we call them, Precepts, can be derived that address the basic tenets of fiduciary responsibility: the duty of loyalty, exclusive purpose and utmost good faith.

Another important influence on the structure of the Practices is the idea of a standard. Using the International Organization for Standardization (ISO) as a model, standards are a body of knowledge that are substantiated and authoritative. Standards are comprised of Practices that detail the application of the Precepts, with each Practice further detailed by Criteria for the implementation of the Practice. Specifically, we have adapted the ISO 9000 standard as an organizational model for the Practices, which is a quality management system that stresses continual improvement (see graphic below).

Using the Precepts as the guiding principles; legislation, regulation and case law for the specific requirements; and organized around the four-step investment management process, we developed the Practices and supporting Criteria, forming a complete Standard. The objectives of the Practices are to define a prudent process that is comprehensive, but not cumbersome, provide a checklist approach to guide any investment fiduciary in the pursuit of fiduciary excellence, and enable any organization to assess its fiduciary process.

The Practices are detailed in the handbooks Prudent Practices for Investment Stewards and Prudent Practices for Investment Advisors, each book containing the same Practices, but with specific information for the implementation of the Practices for the different types of investment fiduciaries. There is also a Prudent Practices for Investment Managers handbook with a different set of Practices for money managers based on best practices. All of the Practices can viewed in the Periodic Table below (click on the image for a larger view), which shows both sets organized within the quality management system.

The Practices are available to the public and intended for all investment fiduciaries who want to strengthen their fiduciary processes. Legal citations in the handbook were provided by the law firm of Reish & Reicher, with full legal substantiation provided in a separate Legal Memoranda handbook. The handbooks also have been reviewed by the Personal Financial Planning Division of the AICPA.  Implementing and demonstrating adherence to the Practices limits liability as a fiduciary, as they help establish evidence that a prudent investment process is being followed and ensure that all fiduciary duties and responsibilities are being addressed by the various parties in the investment process, among other benefits.

This is only a brief introduction to the Practices and we encourage you to download copies of the handbooks for a more thorough introduction and to review the Practices themselves. If you have any questions, let us know either in the comments below, or by emailing us at blog@fi360.com. 

Next month, we'll look in detail at Practice SA-1.1, "Investments are managed in accordance with applicable laws, trust documents, and written investment policy statements."

Is it Time to Get an Outside Opinion?

It's not unusual for those who are in a fiduciary role to be concerned about whether or not they are carrying out their responsibilities adequately.  In light of the recent dramatic downturn in the market, these concerns have increased and many are asking the question, "how often should we get an outside opinion to make sure we are managing the investment assets properly?"  Others wonder, "are we truly meeting our fiduciary obligations?"

There are two fiduciary practices that relate to this question.  The first is Practice 1.4 in the Steward's Handbook. Under that Practice, Criterion 1.4.4 states; "Consideration is given to putting vendor contracts back out for bid every three years."  This does not necessarily mean that a formal RFP (request for proposals) needs to be conducted (although that would be ideal), but there should at least be an informal RFI (request for information) to ensure that what was a good deal three years ago continues to be a good deal. The market is dynamic and fees may have gone down (or up), services offered may have expanded, and legal requirements may have changed. 

Investment advisors or brokers that come through our training often times push back when discussing this criterion, asking why they should advise a client to periodically check to see if they are still the best candidate for the job.  For the investment steward, an ongoing and critical part of their job is to ensure that the fees they pay for services provided are fair and reasonable.  This regular review demonstrates clearly that they are addressing this criterion.  For the investment advisor or broker, they set themselves apart and greatly enhance their creditability with the steward by helping to ensure the stewards meet this fiduciary requirement; even at the risk of losing their client.  Most stewards are reluctant to replace an advisor or broker that clearly demonstrates they have the steward's best interest at heart; although they may need to reduce their fees or expand their services to meet competitive pressures.  It also helps them to keep a close eye on the competition.

Practice 4.6 states that "There is a process to periodically review the organization's effectiveness in meeting its fiduciary responsibilities."  This practice most directly addresses the initial question.  The expectation here is that internal reviews are conducted more frequently, but at times it is necessary to have an outside party evaluate your process to ensure objectivity and impartiality.  The annual review of the IPS (investment policy statement) to determine if it is still consistent with the actual process in place is a large part of the ongoing internal review.  Those organizations that have their fiduciary house in order, however, eventually see the need and benefit of having an outside professional conduct an external review.  The idea would be for the consultant to compare the steward's investment process to the fiduciary practices and determine what is working and what is not.  A worklist is generated to address weaknesses, and, once the process is fully aligned (possibly over several years), consideration can be given to obtaining the fiducary equivalent of the "Good Housekeeping Seal of Approval," a CEFEX Certification. 

Fiduciary Links: 2010 fi360 Conference

Today, early bird registration opened for our 2010 Conference, which is being held May 5-7 in Orlando. It will be our sixth annual conference featuring many of the leading minds in the industry on fiduciary-related topics. It is a valuable event with great content for both fiduciary novices and those who are experienced in fiduciary responsibility alike. You can visit our conference page for more information about this year's and past conferences. We have not yet announced an agenda, but past speakers include Fred Reish, Bob Veres, Lou Harvey of Dalbar, Brian Hamburger, Josh Itzoe of Fixing the 401(k), Matt Hutcheson, Roger Gibson, Susan Mangiero of Pension Risk Matters, and Carl Richards of Behavior Gap, just to name a few. 

The event is exhibitor and sponsor free, and, in addition to the first-rate speakers, has one of the highest caliber of attendees you'll find at an investment industry event. Many of the attendees have been to multiple, if not all, of our past conferences and are at the forefront of incorporating fiduciary processes in to their practices. We encourage you to check us out and feel free to send emails to conference@fi360.com if you have any questions. Early bird prices are only good through November, so register soon!

Now on to the best links of the past week:

In the news/commentary:

• TD Ameritrade and Schwab may be teaming up their advocacy efforts.
• Eight things to keep RIAs from answering to SIFMA
• How SRI can go hand-in-hand with fiduciary principles
• Life planning and the three questions to ask an investor preparing for retirement
• SEC and CFTC propose fiduciary standard for commodities advisors

From the organizations/associations/government/academia:

• The IAA says it supports self-funding of the SEC
• The new Reish Adviser Report looks at benchmarking, 12b-1 fees, legal updates and more.

From the blogs:

• Kate McBride looks at the "authentic" vs. "federal" versions of the fiduciary standard
• Introducing the Fiduciary News blog

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.
 

A Time for Advocacy

After finishing up hearings on financial regulatory reform earlier this month, the House Financial Services Committee began the task of marking up reform legislation this past week.  The Committee reached its first major milestone by passing legislation on over-the-counter derivatives and will continue to push forward on other pieces of legislation in hopes of a full House vote on a reform package in November. 

Fiduciary duties for investment professionals that provide advice continues to be a key piece of the proposed Investor Protection Act of 2009 , which will likely be considered in a mark-up session next week or the following week.  With this legislation looming, industry groups representing different views on the fiduciary standard have been increasingly promoting their advocacy efforts on Capitol Hill.  Just these past couple of weeks the Financial Planning Coalition launched a website, as did the Committee for the Fiduciary Standard, in order to promote fiduciary issues and keep the public abreast of their advocacy activities.  On the broker-dealer side, the new head of the SIFMA Washington office started his new post and will play a key role in the organization's lobbying efforts to promote "a harmonized fiduciary standard." Meanwhile, members of FSI spent a day meeting with Congressional members to promote "a universal standard of care" for investment professionals.  

In an effort to further promote the fiduciary standard, fi360 CEO, Blaine Aikin, urged our readers earlier this week to speak out on behalf of investors and the professionalization of investment advice by contacting legislators and regulators.  Now is a key time for clear and effective advocacy for the fiduciary standard as Congress is moving quickly to consider and implement financial regulatory reform, and key industry groups are jockeying for their views to be heard.   

If you would like to do more to promote the fiduciary standard and ensure that Congress "gets it right", you should contact your Senators and Congressional Representatives as soon as possible.  In addition, you should directly reach out to the Chairman Barney Frank and Ranking Member Spencer Bachus of the House Financial Services Committee and Chairman Christopher Dodd and Ranking Member Richard Shelby of the Senate Committee on Banking.  

Key points to emphasize to Congressional Leaders and your own Senators and Representatives include: 

• To the extent that investment professionals provide similar services, similar protection for investors' interests should also be provided; and in particular, broker-dealers who provide investment advice should be held to the same fiduciary standard of care as investment advisors. 

• As acknowledged by panelists testifying before on the House Financial Services Committee on October 6, 2009, the fiduciary standard is a more stringent and higher standard than the suitability standard that currently applies to brokers.  The fiduciary standard requires investors' interests to be put first and involves more than just checking to ensure that a single investment is appropriate for an investor. 

• Despite claims by SIFMA to the contrary, the principles upon which the fiduciary standard are based are clearly established in law.  (In fact, as Blaine's blog post from Wednesday explains, the Committee for the Fiduciary Standard has identified five core principles, which have been received positively by policymakers in Washington.) 

The message on the fiduciary standard needs to be made simple and clear to legislators who must largely look to regulators and the industry for guidance and education on these issues.  We will continue to keep you updated as regulatory reform continues to develop, and we hope that you will heed the call to action to promote a positive change in regulation on behalf of investors and the profession as a whole.

A true fiduciary standard can't compromise basic principles

In my most recent Fiduciary Corner column in Investment News, I wrote about The Committee for the Fiduciary Standard and the five fiduciary principles the Committee focuses upon. The five principles capture the essence of the fiduciary standard that is well established in law and regulation. They are paraphrased here:

1. Place investors best interests first (singular duty of loyalty to the investor)
2. Provide advice with the skill, care, diligence and judgment of a professional (duty of due care or the prudent expert standard)
3. Provide full and fair disclosure of all material facts (duty of utmost good faith)
4. Avoid conflicts of interest (because conflicts are situations that make fulfillment of the duty of loyalty less reliable)
5. Manage unavoidable conflicts in the best interest of the client (which is meant to assure that the objectivity of the advisor is not impaired)

Some financial service industry trade groups and a handful of transaction-oriented firms are advocating, either overtly or by lobbying legislators behind the scenes, to establish a “new fiduciary standard” that purportedly would draw from both the principles-based fiduciary standard and the lower rules-based fair dealing standard associated with traditional brokerage activities.

While these efforts are couched in terms of finding a workable compromise solution, they amount to a call to abandon the true fiduciary standard and christen the fair dealing standard as the “new fiduciary standard.”

Simply put, you can’t compromise principles and claim to adhere to them.  Consider what it would mean to compromise on the five fiduciary principles.

1. Compromising the singular duty of loyalty results in divided loyalties, which is at odds with the very definition of a fiduciary.
2. Compromising due care results in acceptance of less than a professional level of competence.
3. Compromising on full and fair disclosures results in the suppression of material information and a failure to provide the transparency crucial to relationships of trust.
4. Accepting conflicts of interest that can reasonably be avoided undermines the integrity of the duty of loyalty.
5. Permitting unavoidable conflicts to be merely disclosed rather than managed in the best interests of clients creates a “buyer beware” overtone to client interactions that is inconsistent with the entire concept of professional advice

In short, regulatory reform that compromises fiduciary principles is not reform at all; it is regulatory regression that would weaken investor protections and push the business of investment advice further from becoming a true profession. Moreover, the fiduciary standard stripped of its core principles bears no resemblance to the true standard whatsoever. Please speak out on behalf of investors and the professionalization of investment advice by contacting legislators and regulators, commenting on financial blogs like this one, and joining The Committee for the Fiduciary Standard (www.thefiduciarystandard.org).

Types of investment fiduciaries

Not all investment fiduciaries are created equally. Generally speaking, there are three types of investment fiduciaries, each with specific roles in the investment process. This is an important point of distinction for those who are just beginning to become familiar with the fiduciary concept.

The first type is the investment stewards. These are the trustees, investment committee members, and plan sponsors. While these individuals may have the least amount of investment training, they have the most responsibility. As the first on the fiduciary scene, they are responsible for managing all of the fiduciary responsibilities for a portfolio. Because successfully managing every fiduciary responsibility is beyond the scope of the typical investment steward, the onus is on them to delegate certain responsibilities to professionals who can.  But regardless of what duties are delegated, their duties cannot be completely abdicated, as it is still their duty to manage the overall process, choose prudent experts appropriately, and monitor plan activities.

The second type of fiduciary is the investment advisor. They are the prudent experts who give advice to a plan. They fall under a wide variety of job titles, usually including the words "advisor," "consultant," or "planner." And, under current regulation, not all  professionals who have those titles can be considered a fiduciary. Rather, fiduciary duty in their case is determined by facts and circumstances, beginning with whether they are providing comprehensive and continuous investment advice, the hallmark of an investment advisor who is a fiduciary. The specific fiduciary duties to which they must adhere is dependent on the role they are serving. They may be engaged to perform a specific role, in which case they would only be responsible for fulfilling that role to a fiduciary standard. However, if an advisor begins performing a role, even one for which they are not contractually engaged, the expectation is they will fulfill that role to the fiduciary standard.

Finally, there are the investment managers. Managers are those who make individual securities selections to implement an investment mandate. This would include money managers for mutual funds, separate accounts, and exchange-traded funds. Their fiduciary duty arises from their discretion over assets.

This is a simplistic look at the three basic types of fiduciaries for the fiduciary beginner. In future Fiduciary Basics posts we'll look at the three types in greater detail and go over the specific duties each has to the individual investor and how their role fits into the overall investment process.